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Capital Budgeting

Executive Summary

According to recent surveys, most companies use discounted-cash-flow (DCF) methods to evaluate capital budgeting decisions. DCF methods typically assume that a project's initial cash outlay (ICO) is known with certainty. However, many types of initial outlays have substantial uncertainty, especially those involving the construction of a new facility. This risk affects not only the ICO, but it also affects subsequent depreciation tax shields.

Capital Budgeting

Introduction

The academic literature for assessing risk includes the certainty equivalent approach, the risk adjusted discount rate approach, and sensitivity analysis. A “certainty equivalent” is the certain amount that one would be willing to take in lieu of a risky cash flow. For example, consider a coin toss in which you must pay $100 for heads and $200 for tails. The expected cost is $150, but it is very risky. To avoid this risk, you might be willing to pay a sure $155 rather than take the risky coin toss, even though the sure $155 costs more than the expected $150 cost of the coin toss. With respect to ICO risk, one could, in theory, estimate the certainty equivalent cash outflow for each uncertain (risky) ICO component, based on the expected cash flow and its risk, and use this certainty equivalent rather than the estimated ICO when estimating the project's NPV.

Capital structure

Capital structure of a company defines the way a firm finances its investments through a combination of debt, venture capital (or equity) or financial stocks mixed in nature. The capital structure is, therefore, the composition or, indeed, "structure" of the financial capital of the balance sheet of a company (Gregory, 2010). For example, a company whose capital is composed of 20 millions of Euros of venture capital and 80 million Euros of debt will be for 20% equity financed (financed by venture capital) and 80% debt financed (financed by debt), the ratio of the debt of a company and its capital, in this case 80%, is called leverage. resources, debt or venture capital will determine the capital structure of a company.

Analysis of the capital structure

When analyzing a capital structure of a company it is essential to take in to account the proportion of short term debt and long term debt. Normally the best way to analyze and have a quick snap of the capital structure is to look at the debt to equity ratio of the company. The debt to equity ratio provides with a proportion of debt and equity present in a company's capital structure.

Recommendation for the capital structure

The net present value analysis of the Competition Bikes Inc. has shown that the company will have a negative value of net present value at low demand which is not desirable. While at moderate demand the net present value is slightly greater than the breakeven point. The internal rate of return of the Competition Bikes Inc. is also less than the cost of capital at low demand whereas, the internal rate of return ratio is slightly greater than the cost of capital at high ...

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